The effects of public capital infusions on banks’ risk-shifting to the deposit insurance system in Japan

•Using option pricing based models, we compute the actuarially fair deposit insurance premium and the market value of assets and asset volatility for Japanese banks as implied by their stock prices.•Banks shift risks to the deposit insurer who charges them risk insensitive premiums.•Well-designed regulatory policies in response to the crisis, however, effectively restrain banks’ risk-shifting.•Not only did the introduction of the prompt corrective action discipline insured banks, but large-scale public capital infusions successfully deleveraged banks whose assets are risky, which effectively mitigated banks’ risk-shifting.

Using option pricing based models, we compute the actuarially fair deposit insurance premium and the market value of assets and asset volatility for Japanese banks as implied by their stock prices. The findings based on these variables suggest that banks shift risks to the deposit insurer who charges them risk insensitive premiums. Well-designed regulatory policies in response to the crisis, however, effectively restrain banks’ risk-shifting. Not only did the introduction of the prompt corrective action discipline insured banks, but large-scale public capital infusions successfully deleveraged banks whose assets are risky. This effectively mitigated banks’ risk-shifting.